Chapter 16 Notes: Debt Policy and MM Propositions

Even if new borrowing increases the risk of old bonds, potentially harming old bondholders, this issue is addressed in Chapter 17.
In this chapter, it's assumed that new debt issuance doesn't affect the market value of existing debt.

MM's Proposition 1: In a perfect market, a firm's value is unaffected by its capital structure. Any financing package is as good as another.
Rationale: Issuing fairly priced securities has zero NPV, so substituting one zero-NPV security for another doesn't add value.
Consider two firms:
- Firm U: Unlevered, with equity value $EU$ equal to the firm value $VU$ . ( $EU = VU$ )
- Firm L: Levered, with equity value $EL$ equal to the firm value less the debt. ( $EL = VL - DL$ )
Two investment strategies with the same payoff should have the same price (Law of One Price).
- Strategy 1: Buy 1% of firm U's shares. Investment = $0.01V_U$ , Return = 1% of profits.
- Strategy 2: Buy 1% of firm L's debt and equity. Investment = $0.01DL + 0.01EL = 0.01V_L$ , Return = 1% of profits.
Since both strategies offer the same payoff (1% of profits), $0.01VU = 0.01VL$ . Therefore, $VU = VL$ .
Alternative Strategy:
- Buy 1% of the levered firm's shares. Investment = $0.01EL = 0.01(VL - D_L)$ , Return = 1% of (Profit - Interest).
- Borrow $0.01DL$ and purchase 1% of the unlevered firm's stock. Investment = $0.01(VU - D_L)$ , Return = 1% of (Profits - Interest).
Again, $VU = VL$ .
Investors can